Drafting Tips

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Almost every year at the IFA Annual Legal Symposium in Washington D.C., a panel of distinguished franchise attorneys and state regulators will discuss best practices in drafting a franchise disclosure document in compliance with the FTC Franchise Rule.   This year was no different and the workshop “Thorny FDD Disclosure Issues” offered a number of best practices and tips to help draft an FDD that is compliant with federal rule and state law and will breeze through the state registration process:

25388704 – know the rules
  1. Item 2 (Business Experience). Franchise systems often have a difficult time determining what officers to disclosure. The panelists reminded attendees that when making this decision, the franchisor should ask themselves whether “an individual’s involvement in either sales or operations is such that a franchisee would rely on his or her expertise, formulation of policy, or control of the system.”
  2. Item 3 (Litigation). Remember that the FTC Rule requires that all material terms to a settlement must be disclosed regardless of whether the settlement agreement is confidential. Legal counsel should remind franchise system clients of this fact so they are not surprised when state regulators demand the information be included in Item 3.
  3. Item 6 (Other Fees). Remember to distinguish between negotiated discounts in initial fees verses other fees. Item 5 requires disclosure of discounted initial fees during the last fiscal year but Item 6 does not require the disclosure of discounted royalty deals.
  4. Item 8 (Restrictions on Sources of Products and Services). Item 8 requires franchisors to disclose the precise basis by which a franchisor receives consideration for required purchases or leases made by the franchisees. State regulators interpret this as a requirement to specify a percentage or flat fee amount per item. For example, “franchisor receives a rebates of $300 for each oven purchased.”

With such resources as the FTC Compliance Guide, FTC Frequently Asked Questions and NASAA Disclosure Guidelines, it would seem like there should be nothing up for debate when it comes to FDD drafting.   After attending this workshop, however, it is clear that there are always new tips to learn.

 

The fight against joint employment of franchisors and franchisees took a small hit when the Western District of Pennsylvania (“Court”) chose to allow a franchisee’s employee’s suit to proceed. In Harris v. Midas, et. al., the plaintiff, Hannah Harris (“Harris”), convinced the Court that she had proffered enough evidence to allege a plausible basis to hold the franchisor (“Midas”) as a joint employer and vicariously liable for the franchisee’s conduct with respect to Harris’ sexual harassment claims against her franchisee employer.

In the instant case, the Court looked at three factors commonly employed to evaluate joint employer liability. First, the Court examined Midas’ authority to hire and fire employees, promulgate work rules and assignments and set conditions of employment. While the Court noted that Midas did not have the authority to hire or fire employees, the Court held that Midas could establish work policies. Specifically, the Court pointed to the provisions of the Franchise Agreement that require franchisees to comply with all lawful and reasonable policies imposed by Midas. Those policies specifically include those policies governing the training of personnel. Further, Harris noted that Midas provided guidance to its franchisees on the creation of its employee handbook and the inclusion of a sexual harassment policy, further exerting its control to influence these workplace policies.

Second, the Court held that while Midas did not exert control over the day-to-day supervision of employees, under the Franchise Agreement, Midas had the authority to do so. Notably, the Court cited Midas’ ability to require employees to attend additional training programs. Further, Midas trained the franchisee who, in turn, trained its employees on the Midas system. Lastly, the Court noted Midas’ ability to visit and inspect the franchisee’s location as further evidence of Midas’ potential influence over the day-to-day supervision of the franchisee’s employees. The Court’s reliance on these provisions is worrisome because many franchisors use similar language to protect the uniformity of the brand.

The last factor, Midas’ control over employee records, the Court again made a stretch to connect the dots. The Midas Franchise Agreement stated that Midas has the right to audit and examine the franchisee’s books and records, which, the Court held, could be interpreted to include personnel files if read as broadly as possible.

Furthermore, Harris argued that Midas was vicariously liable for the franchisee’s conduct because the franchisee was essentially acting as Midas’ agent. The Court agreed holding that the terms of the Franchise Agreement are so generally phrased as to provide Midas broad discretionary power to impose nearly any restriction or control it deems appropriate.

While the case at hand is at the initial phase and will likely be subject to further scrutiny, it demonstrates another avenue that courts are using to impose joint employer liability. Here, the Court is relying upon the broad and sweeping provisions of the Franchise Agreement that Midas is using to protect its brand and franchise system. The fine line franchisors must continue to tread between exerting just enough control to ensure proper maintenance of the franchise system but not enough to cause joint employer liability continues.

 

A recent decision in the United States District Court of Arizona (“Court”) could have far-reaching consequences to many franchisors based on the broad-sweeping principles the Court used in its reasoning. In Zounds Hearing Franchising, LLC et. al. v. Bower et. al., the Court answered the question of whether the Ohio Business Opportunity Purchasers Protection Act (BOPPA) trumps a choice of law and venue provision that provides for the application of law other than the State of Ohio.

Here, four franchisees filed suit against Zounds Hearing Franchising, LLC and Zounds Hearing, Inc. (collectively, “Zounds”) in the state court of Ohio for failure to comply with the five-day cancellation requirement under the BOPPA. Further, the aggrieved franchisees claim that Zounds made false, misleading and/or inconsistent representations than that contained in its FDD in connection with the sale of its franchises in violation of the BOPPA. Each Franchise Agreement provides that Arizona law governs the interpretation and enforcement of the Franchise Agreement and all disputes are subject to pre-suit mediation (at Zounds’ option) and venue in Arizona. As such, Zounds moved to remove the suits to Ohio federal court, which then transferred the suits to the instant Court.

In analyzing whether BOPPA should trump the provisions of the Franchise Agreement, the Court relied on the rules of the Restatement of Conflict of Laws. Specifically, the law of the state with the “most significant relationship” to the parties shall govern the agreement or, if the parties chose the law of another state, that state’s law shall govern. However, if the choice of law is contrary to a fundamental policy of the state with the most significant relationship, that state will presume to have the materially greater interest in its state law governing the agreement. In holding that Ohio has the most significant relationship to the parties, the Court noted that all of the franchises and franchisees were located in Ohio and it has a strong interest in protecting its residents, particularly where the underlying statute is designed to protect franchisees that are in an inferior bargaining position. Further, Arizona lacks a statute that protects purchasers of franchises, while BOPPA is directly on point to address the franchisees’ purported harm. Essentially, the franchisees would be left with little recourse against Zounds if Arizona law applied.

Further, the Court held that it is difficult to imagine that a statute that makes certain conduct a crime as being anything but the fundamental policy of the state. Additionally, the Ohio legislature amended the BOPPA in 2012 to explicitly state that any venue or choice of law provision that deprives an Ohio resident of protection thereunder is contrary to public policy, void and unenforceable further evidencing its intent. Lastly, the Court went so far as to say that even if a statute does not explicitly outline that it is fundamental policy of that state, a court still could deem it so by its very nature. Further, the lack of a non-waivability term does not doom the statute under this analysis. These principles may open the door to seemingly endless arguments about what constitutes the fundamental policy of a state.

As such, even though the parties agreed to the Arizona choice of law and venue provisions, the application of Arizona law would be contrary to the public policy of Ohio because Arizona does not have a statute that protects the rights of franchisee purchasers as does Ohio. Further, Ohio has a materially greater interest in the enforcement of its law because the franchisees are Ohio residents and the franchises are located therein.

In the alternative, Zounds filed a motion to compel mediation pursuant to the requirement for pre-suit mediation in Arizona in the Franchise Agreement. Here, the Court determined that the pre-suit mediation requirement violated the franchisees’ rights to Ohio venue because the mediation is “intimately bound up” with the franchisees’ right to sue under the BOPPA. Lastly, the Court determined that the mediations for all four franchisees could be joint despite the Franchise Agreement requiring that all proceedings arising out of the Franchise Agreement be decided on an individual basis. Here, the Court held that because pre-suit mediation was a “proceeding” (as argued by Zounds’ counsel), then the BOPPA prohibitions apply to the mediation requirement and the BOPPA specifically prohibits class action waivers. As such, the requirement to conduct pre-suit mediation was void in violation of the BOPPA. However, the parties conceded to conduct mediation during the course of the suit. As such, the Court required that the parties conduct joint pre-suit mediation. To take it a step further, the Court awarded the franchisees their attorneys’ fees because Zounds burdened the franchisees with a multiplicity of actions in a distant forum. Further, the Court cited the unequal provision in the Franchise Agreement that stated Zounds could recover attorneys’ fees upon a successful claim against a franchisee but did not afford franchisees with a reciprocal right. The Court noted that it would be a presumptive abuse of discretion not to award attorneys’ fees against an unsuccessful party who “used its superior bargaining position to impose such a term”.

Overall, this result could have substantial effects to any franchisor that currently has franchises in Ohio or has Arizona law as its choice of law. This decision suggests courts have wide latitude to determine whether another state has a substantial interest in the transaction and whether that state’s law should govern the agreement. Further, it is important to take note of the consequences this has on a franchisor’s ability to enforce non-binding mediation as a preliminary form of dispute resolution (and on an individual basis) and to collect attorneys’ fees (without a corresponding right afforded to the franchisee). Lastly, it would be prudent for all franchisors to review their franchise agreements in light of this decision.

A federal court in Colorado recently upheld a franchisor’s non-competition provision despite that state’s strong public policy against non-competes. The franchisor prevailed due to its thoughtful contract drafting and ability to effectively communicate the unique nature of franchising to the court.

In-home care franchisor Homewatch International, Inc. and its franchisee, Prominent Home Care, Inc., signed a franchise agreement that terminated on June 30, 2016. The next day, Prominent’s sole shareholder and officer (the “Defendant”), started a competing company. Homewatch sued the Defendant for breach of contract, seeking to enforce the non-competition provisions in their agreements.

The Defendant made two arguments in her defense (i) the franchise agreement’s non-competition provision did not bind her because she signed the franchise agreement only in her executive capacity on behalf of Prominent; and (ii) the non-competition provision was unenforceable under Colorado law.

Argument 1:  Parties Bound
The franchise agreement stated that, after the term of the franchise agreement, Prominent and its officers and shareholders could not own or operate a competing business within a twenty-five mile radius of a Homewatch location. Only Prominent (not the Defendant) signed the franchise agreement. However, the franchisor had also required the Defendant to sign a personal guaranty. The guaranty stated that the Defendant would be bound by the non-competition covenant in the franchise agreement.

The court ruled in the franchisor’s favor. It held that the guaranty unambiguously stated that the Defendant—in her individual capacity—would be bound by the franchise agreement’s non-competition provisions.

Argument 2:  Colorado Policy
Colorado law generally disfavors non-competition provisions. One exception to this rule is for a contract for the purchase and sale of a business. This exception promotes the purchase and sale of businesses by protecting the good will of the business being sold (i.e., a purchaser may be less likely to buy a business if it cannot obtain an enforceable non-compete from the prior owner).

Prior to Homewatch, the courts had not definitively decided whether the sale of a franchise qualified for this exception under Colorado law. The Defendant argued that the exception did not apply because the sale of a franchise is not a sale of a business—instead it is the sale of a license to the franchisor’s methods and intellectual property for a certain term.

The court rejected this argument, holding that the exception applied and the non-compete was enforceable. The court concluded that the “good will” rationale was just as important in the franchise context, noting that a significant portion of the value of a franchise system is its good will. (It should be noted, however, that Homewatch is a federal court opinion. A Colorado state court could come to a different conclusion; however, the state court would likely consider the Homewatch rationale in its decision.)

The Takeaways
Franchisors should take note of the Homewatch decision and ensure that their franchisees’ owners and key employees, especially those with access to confidential materials and training, sign non-competes in their individual capacities. This is often addressed in the personal guaranty, as it was in Homewatch. Franchise systems in states that frown upon non-competition provisions should be aware of the Homewatch rationale in the event they need to enforce their non-competes. Franchisors should also make sure to use experienced franchise counsel. In Homewatch, counsel was able to communicate the unique franchise model to the court and to persuasively argue why the court should apply a law that was probably not drafted with franchising in mind. The result was a win for the franchisor and also franchising, which relies on non-competes to mitigate risks inherent in the franchise model.

The intersection of franchise law and general corporate law is extensive. A recent decision in the Michigan Court of Appeals (Court) highlights the importance of thoroughly understanding and considering the ramifications of transactions involving both spheres of law.

In Retail Works Funding LLC v. Tubby’s Sub Shops Inc. and JB Development LLC, the plaintiff (Plaintiff) brought suit against each defendant (Tubby’s and JBD or collectively, the Defendants) after JBD purchased the rights and goodwill to the service mark JUST BAKED (Mark) from Just Baked Shop LLC (JBS). Prior to that, Plaintiff obtained a judgment against JBS for over $184,000.

In this suit, Plaintiff claims that JBD should be liable for Plaintiff’s judgment under a successor liability theory because JBD is a mere continuation of the Just Baked system by carrying Just Baked products in its stores and offering franchises. Further, Plaintiff argued that JBD held itself out to the public in news articles as having merged with JBS. Defendants argued that JBD only purchased the rights to one asset of the Just Baked business, the Mark, and did not agree to take on any its liabilities as supported by the language of the Service Mark Purchase Agreement.

As was the case here, when assets of a business are purchased with cash and not stock, the successor is generally not liable for the predecessor’s liabilities unless an exception to the rule applies. In holding for the Defendants, the Court determined that none of the three exceptions to successor liability argued by Plaintiff applied to the case at hand. First, the instant case did not constitute a “de facto merger” because JBD purchased the Mark for cash. Second, JBD was not a “mere continuation” of the former Just Baked business because Plaintiff failed to provide any evidence of common ownership between the entities or that JBD acquired substantially all of the assets of JBS. Lastly, the “continuity of enterprise” exception did not apply because judgment creditors cannot rely upon it. As such, the Court held that the Defendants were not liable for the judgment against JBS.

If the deal to purchase the Mark had been structured in a different way, there is a chance that the Defendants would have been held liable for the Plaintiff’s judgment against JBS. As such, a franchisor (and its counsel) must evaluate how a transaction will effect multiple areas of law and ensure adequate protection from adverse consequences in each area.

If a franchisor waives the non-compete provision in its current franchise agreement, can it enforce a non-compete when the franchise agreement is renewed? According to a recent decision by the 9th Circuit Court of Appeals, the answer is yes, and franchisors should consider a few key lessons from the decision. Robinson, DVM v. Charter Practices International, LLC, No. 15-35356 (June 21, 2017).

In Robinson, a franchisee sued its franchisor for breach of contract and other claims when the franchisor refused to renew their franchise agreement for a veterinary hospital franchise. During the term of the original franchise agreement, the franchisee owned and operated independent veterinary clinics that competed with the franchise. The franchisor did not enforce the non-competition provision in the original franchise agreement. However, when it came time for renewal, the franchisor notified the franchisee that it would enforce the non-compete under the renewal agreement and gave the franchisee an opportunity to disinvest from his independent clinics. The franchisee refused, and the parties did not renew the franchise agreement. The franchisee sued the franchisor alleging improper refusal to renew under Oregon law.

The district court dismissed the franchisee’s claims and the 9th Circuit affirmed. The court’s decision holds three important lessons:

  1. The renewal provision specifically allowed the franchisor not to renew the original franchise agreement unless the franchisee complied with the non-competition provision in the renewal agreement. Renewal provisions typically (and should) include general language requiring the franchisee to acknowledge it will be bound by the new franchise agreement. However, it is often wise to specifically reference sensitive provisions, including non-competes and other restrictive covenants and confidentiality provisions.
  2. The renewal provision in the original franchise agreement stated that the renewal agreement would be substantially similar to the franchisor’s then-current form of franchise agreement. It made clear that the terms could differ from the original franchise agreement. This language highlighted that the original agreement and renewal agreement were different contracts. The court used concluded that the waiver of the non-compete under the original franchise agreement did not carry over into the renewal agreement.
  3. The franchisor provided notice to the franchisee that it intended to enforce the non-competition provision, and it gave the franchisee an opportunity to disinvest. The franchisee argued that he and the franchisor had a “course of conduct” that permitted him to compete. According to the court, the franchisor’s notice disrupted this course of conduct, and therefore the waiver under the original franchise agreement did not apply to the new agreement.

Franchisors (especially emerging franchisors) may find it necessary to waive provisions in their form of franchise agreement to close the deal with a prospect. While this may make sound business sense at one point in time, it can chafe down the road. As Robinson shows, a carefully drafted renewal provision and notice may provide an escape hatch in certain situations.

Janitorial services franchisor Jan-Pro Franchising International, Inc. (“Jan-Pro”) is not the employer of its unit franchisees, according to a recent California federal court decision. Roman v. Jan-Pro Franchising Int’l, Inc., No. C 16-05961 WHA (N.D. Cal. May 24, 2017). The plaintiff franchisees failed to show that Jan-Pro exercised sufficient control over their day-to-day employment activities.

Copyright: stocksolutions / 123RF Stock Photo

What makes this case unique is that Jan-Pro operates a three-tiered franchising structure, often called a subfranchise arrangement. Under this arrangement, Jan-Pro grants subfranchise rights to a regional master franchisee (“Master Franchisee”), who is responsible for selling Jan-Pro unit franchises to individual franchisees (“Unit Franchisees”) in a particular geographic territory. The Unit Franchisees operate the franchised cleaning service business. Importantly, as is common in a subfranchise arrangement, Jan-Pro never directly contracts with its Unit Franchisees. Instead, Jan-Pro directly contracts with its Master Franchisees. Then, the Master Franchisees directly contract with the Unit Franchisees.

 

The plaintiff Unit Franchisees claimed that they were misclassified as independent contractors when they were really Jan-Pro’s employees. They sought minimum wages and overtime premiums from Jan-Pro. The plaintiffs argued that they were Jan-Pro’s employees under California law because the contracts between Jan-Pro and its Master Franchisees permitted Jan-Pro to control the business of the Master Franchisees and Unit Franchisees through its policies and procedures.

Under California law, “to employ” means

  1. To exercise control over the wages, hours or working conditions, or
  2. To suffer or permit to work, or
  3. To engage, thereby creating a common law employment relationship.

Martinez v. Combs, 49 Cal. 4th 35, 64 (2010). However, in the franchise context, controlling the “means and manner” of a franchisee’s operations is not sufficient to make a franchisor an employer. A franchisor is only an employer if it retains or assumes general control over employment matters such as hiring, direction, supervision, discipline and discharge. Patterson v. Domino’s Pizza, LLC, 60 Cal. 4th 474, 498 (2014).

The court concluded that Jan-Pro did not employ the Unit Franchisee’s employees. It reached this result despite the fact that the Master Franchisees exerted control over the Unit Franchisees under the contracts between them. Critical to the court’s analysis was the fact that these contracts did not confer any rights on Jan-Pro to control or terminate the Unit Franchisees. Nor was Jan-Pro a third party beneficiary of these agreements, which could give Jan-Pro the right to directly enforce them. Moreover, Jan-Pro never directly contracted with the Unit Franchisees.

The court’s analysis focused on features that are specific to subfranchise arrangements, especially the lack of a direct contractual relationship between Jan-Pro and its Unit Franchisees. A subfranchise arrangement is only one form of multi-unit arrangement, and is not appropriate for all franchise systems. Franchisors engaged in or considering this system should perhaps not put too much emphasis on the court’s analysis. For one thing, a franchisor may want to have some contractual rights it can enforce directly against Unit Franchisees. Additionally, even if Jan-Pro had directly contracted with Unit Franchisees, there appeared to be scant evidence that Jan-Pro controlled employment conditions in a manner that would make it a joint employer. However, if a franchisor were to indirectly control employment conditions through a subfranchise arrangement, a court might come to a different conclusion. In any event, the court’s decision was well reasoned and grounded in a firm understanding of franchising. It was certainly a win for the franchise model, made especially important by the fact that it took place in California, which is typically considered an employee and franchise friendly jurisdiction.

Many franchisors employ arbitration as its preferred method of dispute resolution.  Generally, courts view arbitration agreements favorably. An agreement to arbitrate waives the fundamental right to have a court decide the merit of their disputes. As such, valid, enforceable arbitration agreements are required to waive this essential right. Two recent decisions highlight the importance of ensuring that a valid agreement to arbitrate exists between the parties.

arbitration agreement
Copyright: designer491 / 123RF Stock Photo

Theo’s Pizza, LLC v. Integrity Brands, LLC

In this case, the franchisee sued the franchisor for violation of the South Carolina Business Opportunity Sales Act and breach of contract. The franchisor sought to dismiss the action because all actions related to the franchise agreement were subject to arbitration (per the Franchise Agreement). The parties entered into a Market Development Agreement under which the franchisor granted franchisee the right to open multiple units. The Market Development Agreement explicitly stated that the parties must execute a separate franchise agreement for each unit. Despite the franchisee opening its first unit, the parties never signed a Franchise Agreement. The Market Development Agreement and Franchise Agreement both contain clauses that require arbitration of all disputes.

The Court held that the claims arose out of the operation the unit, not the Market Development Agreement.  Thus, in the Court’s opinion, there was not an explicit agreement to arbitrate disputes because the parties never signed the Franchise Agreement.  Additionally, the Court refused to impute an agreement to arbitrate where the franchisee had not expressly agreed to one.

Stockade Companies, LLC v. Kelly Restaurant Group, LLC

In this case, the franchisor terminated the Franchise Agreement for failure to pay royalties. The franchisee continued to operate its business after the termination of the Franchise Agreement. Subsequently, the franchisor filed for an injunction against the franchisee for its continued operation of its business. The franchisor argued that the franchisee’s continued operation of the business infringed on franchisor’s trademark rights and violated the post-termination non-competition clause. The franchisee argued that the franchisor was not entitled to an injunction because all actions under the Franchise Agreement must be arbitrated. However, the Franchise Agreement provided that the franchisor may file for injunctive relief where necessary to protect its proprietary marks and other rights or property.

The franchisee argued that the claims fall within the arbitration clause because (a) they are not “actions” within the meaning of the exclusion clause, (b) they are not “necessary” to protect the franchisor’s property, and (c) the exclusion clause is vague and invalid. The Court dismissed each of the franchisee’s arguments noting that the exclusion clause permits the specific action the franchisor took (the filing of a request for injunctive relief). Further, the franchisor’s (i) right to enforce its non-compete protects its property, and (ii) trademark infringement claims protect its proprietary marks. Lastly, the Court noted that the language of the exclusion clause was clear and that the franchisor had carved out its right to seek injunctive relief. As such, the Court held there was no valid agreement to arbitrate the injunction action.

Conclusion

These cases illustrate it is of utmost importance to ensure that your franchise agreements are well-written and explicit when it comes to dispute resolution procedures. Additionally, when entering into a development relationship, a franchisor must ensure that it enters into a separate franchise agreement for each unit so it is bound by those terms. Lastly, a franchisor must ensure that all reserved rights to obtain injunctive relief are clear and conspicuous. While these recommendations are not earth-shattering, these cases are important reminders of the consequences of improper franchise administration and documentation.

The interpretation and enforcement of non-competition covenants is always a hot button issue and varies from state to state. In Our Town v. Michael Rousseau and Jennifer Rousseau, the United States District Court for the Middle District of Pennsylvania (“Court”) granted a temporary restraining order filed by a franchisor, Our Town, against its former franchisees to prohibit them from operating a competing business in direct violation of the terms of the franchise agreement.

Copyright: jossdiim / 123RF Stock Photo
Copyright: jossdiim / 123RF Stock Photo

Here, on the same day that the former franchisees sent a letter to Our Town in November 2016 to inform Our Town that it was terminating the franchise relationship, Our Town learned that the former franchisees were operating a similar publication called “Home Town” in the same geographical region as its former franchised business.

As such, Our Town filed for a temporary restraining order to prevent such competitive conduct because it violation of the franchise agreement. In interpreting non-competition covenants in franchise relationships in Pennsylvania, courts look to the rule in Piercing Pagoda, Inc. v. Hoffner, which provides that non-competition clauses will be upheld in Pennsylvania if the clause relates to a contract for the sale of goodwill or other proprietary interests, the clause is supported by sufficient consideration, and the restriction is reasonably limited in time and scope. The Court first determined that the covenant is ancillary to sale of a business interest (the Our Town franchise and its goodwill) and that the $3,800 franchise fee was sufficient consideration.

Next, the Court analyzed the language of the franchise agreement in connection with the Piercing Pagoda standard, which provided that the former franchisees could not operate any business that is similar to the former franchised business for a period of three years after the termination or expiration of the franchise agreement either at the franchise location or within fifty miles of any Our Town franchised location. Further, the franchise agreement provided Our Town with the right to seek injunctive relief for violations of the non-competition covenant. The Court held that these restrictions were reasonable because other courts in Pennsylvania had also held three-year time limits and 50-mile geographical limits to be reasonable. However, please note that the Court did not specifically rule on whether the entire geographical restriction was reasonable; only that part which applies to the operation of a competing business in the same location as the former franchised business. As such, in granting the temporary restraining order, the Court held that Our Town was likely to succeed in showing that the former franchisees acted in direct violation of the franchise agreement and that such provisions of the franchise agreement were enforceable. Further, the Court held that Our Town will suffer irreparable injury in the absence of this relief because Our Town’s legitimate business interests will be affected and the harm to the non-moving party, former franchisees, weighs in favor of granting the injunction due to the self-inflicted nature of the harm.

With that said, drafting an enforceable non-competition covenant is a very complicated task and should be approached with care. It is important to keep in mind that all restrictions must be reasonable in geography, time and scope of activities. Lastly, it is important that a franchise agreement contain language that provides a franchisor with the immediate right to obtain injunctive relief to stop such behavior.

If your brand standards require franchisees to upgrade and improve their locations, a recent federal case demonstrates how thoughtful disclaimers and disclosures can shut down a franchisee lawsuit in its early stages. 

In Devayatan, LLC v. Travelodge Hotels, Inc., a franchisor terminated a franchise agreement due to the franchisee’s alleged failure to improve and maintain a hotel in accordance with brand standards.  No. 6:14-cv-561-Orl-41TBS (June 24, 2016 M.D. Fla.).  The franchisee filed suit, alleging the franchisor negligently misrepresented the amount of required repairs and violated Florida’s Deceptive and Unfair Trade Practices Act (“FDUTPA”).  Citing the franchisor’s multi-pronged disclosure of the franchisee’s improvement and maintenance obligations, the Court granted the franchisor’s motion for summary judgment, stopping the franchisee’s claims short of trial.

In Devayatan, a franchisee signed a franchise agreement with hotel franchisor Travelodge Hotels, Inc. (“THI”).  A prior franchisee had been operating the hotel under a franchise agreement with THI, but the hotel was in a state of disrepair and the prior franchisee was in default of its maintenance obligations.

THI put the new franchisee on notice that it would be responsible for bringing the hotel up to brand standards.  The franchise disclosure document estimated the initial investment ranged from $177K to $1.4M, depending on the condition of the property.  The franchise agreement also provided a “punch list” of items that were not in compliance with brand standards.

When the real list of repairs far exceeded the punch list (including curing multiple legal violations), the franchisee cried foul.  The franchisee claimed that the franchisor negligently misrepresented that the punch list was a complete list of required improvements.  However, the negligent misrepresentation claim required “justifiable reliance” on an incorrect statement and the FDUTPA claim required statements that were “likely to mislead.”  Thanks to thoughtful drafting, both claims missed the mark.

Several features of the FDD and franchise agreement proved valuable in defeating the franchisee’s legal claims:

  • First, the FDD disclosed a broad range of possible initial investments, and indicted that the range was based on the condition of the property.
  • Second, the franchise agreement clearly indicated that the punch list was based on a “random sample inspection” and did not purport to be a complete list based on a full inspection.
  • Third, the punch list explained that the franchisee was “responsible for ensuring that the hotel was in compliance with all applicable federal, state and local laws, codes, ordinances and regulations.” The punch list explicitly stated that such renovations were not included.

2528605_sThus, the court found the franchisee unreasonably assumed that the punch list was a complete list of repairs and that the franchisor’s statements were not likely to mislead.

Franchisors often require franchised locations to be improved and maintained according to continually evolving brand standards.  Franchisors may find it beneficial to provide a punch list of repairs or other assistance the help franchisees to meet their obligations.  However, franchisors should take care that their good deed is not punished.  Devayatan provides a few lessons:

  1. FDDs and franchise agreements should clearly state and disclose franchisee’s obligations to improve and maintain their locations and, where appropriate, disclose the amount or range of amounts for such expenses.
  2. Punch lists or similar documents should not attempt to list every single repair and improvement. Doing so may require a franchisor to bear the burden of inspection and assume the risk of any issues not included.  Any such list should clearly state that it is not a complete list.
  3. Franchisees often assume the responsibility of complying with federal, state and local laws and ordinances. If this is the case, a list of improvements and maintenance should explicitly state that it does not include renovations required for such compliance.

Unfortunately, proper disclaimers and disclosures can only make a lawsuit less likely, not prevent it altogether.  But they may help achieve dismissal in the early stages of a lawsuit, saving the money and time that would otherwise be spent at trial or in settlement.